The Corner for the edition of June 20, 2014

Among the many approaches to analyzing the outlook for the stock market are those most popular with “value analysts.” They typically involve a study of various corporate productivity measures such as dividends, earnings and book value. Included among “psychological market indicators” are three of the yardsticks most often used to determine if the market is overvalued, undervalued or fairly valued.

These indicators are:

• The price-to-book value of the Dow Jones Industrial Average (DJIA)

• The price-to-earnings ratio of the DJIA

• The dividend yield of the DJIA

The price-to-book value of the DJIA is found by taking the sum of the assets minus the liabilities of all of the 30 stocks making up the blue-chip index. The figure, called net worth, is divided by the shares outstanding to derive the book value, which is then compared to the combined prices of the 30 DJIA stocks.

The book value does have a degree of inaccuracy in that it does not always reflect the true net worth of a firm because of various methods of accounting. However, the method and final figure most often used is the best possible and serves the purpose well. It is widely used by value analysts.

When the price-to-book value is low, the market is considered undervalued; when it is high, it may be viewed as overvalued. The price-to-book reached one of its highest points—4.50—in June of 1987, when the Dow was around 2,300—four months and 400 points before the 1987 Crash in October.  One of its lowest levels was 1.06 in January of 1983, when the Dow was at 1,050 and in the middle of the first leg of the 1980s bull market.

The price-to-earnings ratio of the DJIA is calculated by dividing the current price of the stocks into the earning for the past 12 months. Because of the increase in “unconventional” accounting practices over the past years, many analysts do not include onetime items in calculating earnings. When many companies go through restructurings during the same time, exclusion of extraordinary items sometimes creates major discrepancies between the Dow P-E published in different places. I believe the exclusion of onetime items is the best way to go.

When the P-E ratio is high, the market is considered pricey. If it’s low, the market is considered undervalued. Many “value” money managers will not buy stocks if P-Es are above certain levels.  This in itself can put a damper on the market.

Value investors complained at various points during the 1980s that they had a hard time finding low P-E stocks; and rightly so. The P-E for the DJIA hit an abnormally high 22.1 in August of 1987; probably the clearest ward of a market top. Then in 1999 as the Dotcom Bubble reached its highs, the DJIA P-E reached 44.2.

The last of the “value indicators” is the dividend yield of the DJIA. This is total dividend yield on the 30 stocks that make up the DJIA. A reading below 3 percent is considered a market that is overvalued and yields above 6 percent are considered a market that is undervalued. This also flashed a yellow light to investors prior to the 1987 Crash. The yield on the DJIA slipped to a five-year low of 2.58 percent in late August, five weeks before the big drop.

According to Investment Quality Trends, “The DJIA has offered historically good value whenever the dividend-yield has risen to 6.0 percent, as it did in 1949 to 1953, 1974 and from 1978 to 1982. Strong price support also has been evidenced at the 4.0 percent yield level, which halted and reversed declines in 1960, 1962, 1966, 1971 and, notably, on October 19, 1987. A 5.0 percent yield halted and reversed a major decline in 1970. More recently, the DJIA came within a hair of the 5.0 percent yield level on an intra-day basis on March 9, 2009.

With the exception of the period between 1994 and 2007, when the price of the Dow reaches a 3.0 percent yield a Rising Trend has been reversed. This occurred in 1950, 1961, 1966, 1968, 1973, 1987 and 1990. If we were to produce a chart all the way back to 1929, it would reveal that the dividend-yield at the top of the market in that infamous year was also just under 3.0%. “

Quote of the Week: “The penalty of success is to be bored by people who used to snub you.” — Lady Nancy Astor

Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.

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